Information Reliability and Welfare: A Theory of Coarse Credit Ratings
46 Pages Posted: 24 May 2014
Date Written: May 22, 2014
An enduring puzzle is why credit rating agencies (CRAs) use a few categories to describe credit qualities lying in a continuum, even when ratings coarseness reduces welfare. We model a cheap-talk game in which a CRA assigns positive weights to the divergent goals of issuing firms and investors. The CRA wishes to inflate ratings, but prefers an unbiased rating to one whose in ation exceeds a threshold. Ratings coarseness arises in equilibrium to preclude excessive rating inflation. We show that competition among CRAs can increase ratings coarseness. We also examine the welfare implications of regulatory initiatives.
Keywords: credit ratings, coarseness, cheap talk, credit quality
JEL Classification: D82, D83, G24, G28, G31, G32
Suggested Citation: Suggested Citation